One of the most common investments that people purchase is a mutual fund. So the question is, what is a mutual fund? We’ll define mutual funds, provide an example of a good mutual fund choice, and also discuss what index funds. Then we’ll summarize with some brief takeaways.
Definition: What are mutual funds?
A mutual fund is an investing instrument which allows someone to purchase a collection of stocks and/or bonds all at once.
The way a mutual fund is formed is that someone creates an investment company which they then use to purchase individual stocks and bonds. Mutual funds could own as few as 20-30 stocks or as many as thousands. The person or company that makes the investing decisions is called the mutual fund manager. The manager charges an ongoing fee in exchange for making the investment decisions for everyone who invests in the mutual fund. This fee is called an expense ratio. The expense ratio is expressed as a percentage of the total assets of the mutual fund, and is expressed as an annualized percent.
One of my favorite mutual funds which I like to recommend is the Vanguard “Total Stock Market Index Admiral Shares.” Vanguard is one of the brokerage companies which I recommend for Passive and Active Investors, interested in purchasing mutual funds. You can see the full list of my recommendations on my resources page.
This fund has the symbol VTSAX, and charges an expense ratio of 0.05%. This expense ratio means that for every $1,000 that you invest in the mutual fund, Vanguard will charge you just $0.50 per year. This is one of the lowest expense ratios available, so don’t think that this is normal. Most mutual funds have expense ratios ranging from 1-2%. I don’t recommend that you use any mutual funds that have greater than a 0.50% expense ratio. (Which is 10x higher than this fund.)
The goal of this mutual fund aligns exactly with it’s name. Vanguard hopes to index against the entire stock market. This means that the fund will purchase shares of thousands of companies with the goal of matching the overall performance of the entire US Stock market. One way to think about it, is that when you own this mutual fund, you are a partial owner of every single publicly traded United States company. In reality, this isn’t true, because most of the time, mutual funds use sampling and they don’t just buy every single company. However, they will be close.
Admiral Shares refer to the share class of the fund. Funds will often have multiple share classes, such as Institutional Shares, Admiral Shares, Investor Shares, and ETF shares. Institutional Shares tend to be the best with the lowest costs, but Admiral Shares are the best one can expect to find outside of a 401k. Each share class usually has an investment minimum that is required to be met before you can move up to the next level.
Index Funds – Passive vs Active Investment management
Vanguard’s Total Stock Market Index is also an index fund. An Index Fund is a type of mutual fund, which is passively managed, with the goal of tracking some larger “index” of companies. These indexes can be the S&P 500, the Dow Jones Industrial Average, or even as with this fund, the entire US stock market. Another common index is the NASDAQ.
Passive management is when a mutual fund manager doesn’t actively pick and choose what stocks to include in the mutual fund. Instead, of trying to outperform a benchmark index, they seek to simply match whatever an overall index does in terms of market gains and losses. This will sometimes involve the use of a formula to know when and what companies to include in the mutual fund, other times it will be done manually. The key is that the goal of an index fund is to exactly match the performance of an index, in others perform right along with the average.
In contrast, active management makes choices to add or remove stocks or bonds from the mutual fund with the goal to either increase returns or reduce volatility. Reducing volatility is only a goal because it is theorized that doing so, will improve long-term returns. At the end of the day, active managers of mutual funds hope to outperform whatever benchmark index they are working against. This means that if the S&P 500 was the benchmark index and it returns 7% in 2016, then an active manager would try and return more than 7% in that year. However, this active management doesn’t come cheap. Active managers charge a higher expense ratio than passive managers of index funds. This is where the average of 1-2% expense ratios arise. The problem is that if an active mutual fund manager charges you a 2% expense ratio, they would need to return more than 9% to make it worth buying over an index fund. (For our S&P 500 example above). This is because 9%-2%=7%. Most managers are unable to beat their index, and very few can do so with their fees taken into account and for a long period time. They exist, such as Warren Buffett, but they are few and far between.
Mutual funds are great instruments for investing that allow you to purchase a whole basket of stocks with a single investment. It is important that you pay attention to the expenses that you have to pay for the mutual fund. Passive index funds tend to be cheaper than more actively managed funds and will tend to have better performance over a long time period. Your goal is to maximize the rate of return on your investments, which means minimizing your expenses. This includes the expense ratio on your mutual funds.
Do you own any mutual funds? What is their expense ratio and could you possibly improve it? Share with us in the comments below, so we can all learn together.